Types of Bonds -- Investing in Bonds


In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and is obliged to repay the principal and interest (the coupon) at a later date, termed maturity.

Other stipulations may also be attached to the bond issue, such as the obligation for the issuer to provide certain information to the bond holder, or limitations on the behavior of the issuer.

Bonds are generally issued for a fixed term longer than ten years. U.S. Treasury securities issue debt with life of ten years or more, which is a bond. New debt between one year and ten years is a "note", and new debt less than a year is a "bill".


A bond is simply a loan, but in the form of a security, although terminology used is rather different. The issuer is equivalent to the borrower , the bond holder to the lender , and the coupon to the interest . Bonds enable the issuer to finance long-term investments with external funds. Note that certificates of deposit (CDs) or commercial paper are considered to be money market instruments and not bonds.

In some nations, both terms bonds and notes are used irrespective of the maturity. Market participants normally use the terms bonds for large issues offered to a wide public and notes for smaller issues originally sold to a limited number of investors. There are no clear demarcations. There are also "bills" which usually denote fixed income securities with terms of three years or less, from the issue date, to maturity. Bonds have the highest risk, notes are the second highest risk, and bills have the least risk. This is due to a statistical measure called duration, where lower durations mean less risk and are associated with shorter term obligations.

Bonds and stocks are both securities, but the major difference between the two is that stock-holders are the owners of the company (i.e., they have an equity stake), whereas bond-holders are lenders to the issuing company. Another difference is that bonds usually have a defined term, or maturity, after which the bond is redeemed, whereas stocks may be outstanding indefinitely. An exception is a consol bond, which is a perpetuity (i.e., bond with no maturity).

Issuers

The range of issuers of bonds is very large. Almost any organization could issue bonds, but the underwriting and legal costs can be prohibitive. Regulations to issue bonds are very strict. Issuers are often classified as follows:

  • Supranational agencies, such as the European Investment Bank or the Asian Development Bank issue supranational bonds.
  • National Governments issue government bonds in their own currency. They also issue sovereign bonds in foreign currencies.
  • Sub-sovereign, provincial, state or local authorities (municipalities). In the U.S. state and local government bonds are known as municipal bonds.
  • Government sponsored entities. In the U.S., examples include the Federal Home Loan Mortgage Corporation (Freddie Mac), the Federal National Mortgage Association (Fannie Mae), and the Federal Home Loan Banks. The bonds of these entities are known as agency bonds, or agencies.
  • Companies (corporates) issue corporate bonds.
  • Special purpose vehicles are companies set up for the sole purpose of containing assets against which bonds are issued, often called asset-backed securities.

Issuing bonds

Bonds are issued by public authorities, credit institutions, companies and supranational institutions in the primary markets. The most common process of issuing bonds is through underwriting. In underwriting, one or more securities firms or banks, forming a syndicate, buy an entire issue of bonds from an issuer and re-sell them to investors. Government bonds are typically auctioned.

Features of bonds

The most important features of a bond are:

  • nominal, principal or face amount the amount on which the issuer pays interest, and which has to be repaid at the end.
  • maturity date--the date on which the issuer has to repay the nominal amount. As long as all payments have been made, the issuer has no more obligations to the bond holders after the maturity date. The length of time until the maturity date is often referred to as the term or tenor or maturity of a bond. The maturity can be any length of time, although debt securities with a term of less than one year are generally designated money market instruments rather than bonds. Most bonds have a term of up to thirty years. Some bonds have been issued with maturities of up to one hundred years, and some even do not mature at all. In early 2005, a market developed in euros for bonds with a maturity of fifty years. In the market for U.S. Treasury securities, there are three groups of bond maturities:
    • short term (bills): maturities up to one year;
    • medium term (notes): maturities between one and ten years;
    • long term (bonds): maturities greater than ten years.
  • coupon--the interest rate that the issuer pays to the bond holders. Usually this rate is fixed throughout the life of the bond. It can also vary with a money market index, such as LIBOR, or it can be even more exotic. The name coupon originates from the fact that in the past, physical bonds were issued which had coupons attached to them. On coupon dates the bond holder would give the coupon to a bank in exchange for the interest payment.
  • coupon dates—the dates on which the issuer pays the coupon to the bond holders. In the U.S., most bonds are semi-annual, which means that they pay a coupon every six months. In Europe, most bonds are annual and pay only one coupon a year.
  • indenture or covenants-- a document specifying the rights of bond holders. In the U.S., federal and state securities and commercial laws apply to the enforcement of those documents, which are construed by courts as contracts. The terms may be changed only with great difficulty while the bonds are outstanding, with amendments to the governing document generally requiring approval by a majority (or super-majority) vote of the bond holders.
  • Optionality: a bond may contain an embedded option; that is, it grants option like features to the buyer or issuer:
    • callability--Some bonds give the issuer the right to repay the bond before the maturity date on the call dates; see call option. These bonds are referred to as callable bonds. Most callable bonds allow the issuer to repay the bond at par. With some bonds, the issuer has to pay a premium, the so called call premium. This is mainly the case for high-yield bonds. These have very strict covenants, restricting the issuer in its operations. To be free from these covenants, the issuer can repay the bonds early, but only at a high cost.
    • puttability--Some bonds give the bond holder the right to force the issuer to repay the bond before the maturity date on the put dates; see put option .
    • call dates and put dates ”the dates on which callable and puttable bonds can be redeemed early. There are four main categories.
      • A Bermudan callable has several call dates, usually coinciding with coupon dates.
      • A European callable has only one call date. This is a special case of a Bermudan callable.
      • An American callable can be called at any time until the maturity date.
      • A death put is an optional redemption feature on a debt instrument allowing the beneficiary of the estate of the deceased to put (sell) the bond (back to the issuer) in the event of the beneficiary's death or legal incapacitation. Also known as a "survivor's option".
  • sinking fund provision of the corporate bond indenture requires a certain portion of the issue to be retired periodically. The entire bond issue can be liquidated by the maturity date. If that is not the case, then the remainder is called balloon maturity. Issuers may either pay to trustees, which in turn call randomly selected bonds in the issue, or, alternatively, purchase bonds in open market, then return them to trustees.
  • convertible bond lets a bondholder exchange a bond to a number of shares of the issuer's common stock.

Types of bonds

  • Fixed rate bonds have a coupon that remains constant throughout the life of the bond.
  • Floating rate notes (FRN's) have a coupon that is linked to a money market index, such as LIBOR or Euribor, for example three months USD LIBOR + 0.20%. The coupon is then reset periodically, normally every three months.
  • High yield bonds are bonds that are rated below investment grade by the credit rating agencies. As these bonds are relatively risky, investors expect to earn a higher yield. These bonds are also called junk bonds.
  • Zero coupon bonds do not pay any interest. They trade at a substantial discount from par value. The bond holder receives the full principal amount as well as value that has accrued on the redemption date. An example of zero coupon bonds are Series E savings bonds issued by the U.S. government. Zero coupon bonds may be created from fixed rate bonds by financial institutions by "stripping off" the coupons. In other words, the coupons are separated from the final principal payment of the bond and traded independently.
  • Inflation linked bonds , in which the principal amount is indexed to inflation. The interest rate is lower than for fixed rate bonds with a comparable maturity. However, as the principal amount grows, the payments increase with inflation. The government of the United Kingdom was the first to issue inflation linked Gilts in the 1980s. Treasury Inflation-Protected Securities (TIPS) and I-bonds are examples of inflation linked bonds issued by the U.S. government.
  • Other indexed bonds, for example equity linked notes and bonds indexed on a business indicator (income, added value) or on a country's GDP.
  • Asset-backed securities are bonds whose interest and principal payments are backed by underlying cash flows from other assets. Examples of asset-backed securities are mortgage-backed securities (MBS's), collateralized mortgage obligations (CMOs) and collateralized debt obligations (CDOs).
  • Subordinated bonds are those that have a lower priority than other bonds of the issuer in case of liquidation. In case of bankruptcy, there is a hierarchy of creditors. First the liquidator is paid, then government taxes, etc. The first bond holders in line to be paid are those holding what is called senior bonds. After they have been paid, the subordinated bond holders are paid. As a result, the risk is higher. Therefore, subordinated bonds usually have a lower credit rating than senior bonds. The main examples of subordinated bonds can be found in bonds issued by banks, and asset-backed securities. The latter are often issued in tranches. The senior tranches get paid back first, the subordinated tranches later.
  • Perpetual bonds are also often called perpetuities. They have no maturity date. The most famous of these are the UK Consols, which are also known as Treasury Annuities or Undated Treasuries. Some of these were issued back in 1888 and still trade today. Some ultra long-term bonds (sometimes a bond can last centuries: West Shore Railroad issued a bond which matures in 2361 (i.e. 24th century)) are sometimes viewed as perpetuities from a financial point of view, with the current value of principal near zero.
  • Bearer bond is an official certificate issued without a named holder. In other words, the person who has the paper certificate can claim the value of the bond. Often they are registered by a number to prevent counterfeiting, but may be traded like cash. Bearer bonds are very risky because they can be lost or stolen. Especially after federal income tax began in the United States, bearer bonds were seen as an opportunity to conceal income or assets. [1] U.S. corporations stopped issuing bearer bonds in the 1960s, the U.S. Treasury stopped in 1982, and state and local tax-exempt bearer bonds were prohibited in 1983. [2]
  • Bear bond , often confused with Bearer bond, is a bond issued in Russian roubles by a Russian entity in the Russian market.
  • Registered bond is a bond whose ownership (and any subsequent purchaser) is recorded by the issuer, or by a transfer agent. It is the alternative to a Bearer bond. Interest payments, and the principal upon maturity, are sent to the registered owner.
  • Municipal bond is a bond issued by a state, U.S. Territory, city, local government, or their agencies. Interest income received by holders of municipal bonds is often exempt from the federal income tax and from the income tax of the state in which they are issued, although municipal bonds issued for certain purposes may not be tax exempt.
  • Book-entry bond is a bond that does not have a paper certificate. As physically processing paper bonds and interest coupons became more expensive, issuers (and banks that used to collect coupon interest for depositors) have tried to discourage their use. Some book-entry bond issues do not offer the option of a paper certificate, even to investors who prefer them. [3]
  • Lottery bond is a bond issued by a state, usually a European state. Interest is paid like a traditional fixed rate bond, but the issuer will redeem randomly selected individual bonds within the issue according to a schedule. Some of these redemptions will be for a higher value than the face value of the bond.
  • War bond is a bond issued by a country to fund a war.

Trading and valuing bonds

The interest rate that the issuer of a bond must pay is influenced by a variety of factors, such as current market interest rates, the length of the term and the credit worthiness of the issuer.

These factors are likely to change over time, so the market value of a bond can vary after it is issued. Because of these differences in market value, bonds are priced in terms of percentage of par value. Bonds are not necessarily issued at par (100% of face value, corresponding to a price of 100), but all bond prices converge to par when they reach maturity. This is because if the prices do not converge, arbitrageurs can make risk-free profit by buying the bonds at a discount and collecting the face value at maturity. At other times, prices can either rise (bond is priced at greater than 100), which is called trading at a premium, or fall (bond is priced at less than 100), which is called trading at a discount. Most government bonds are denominated in units of $1000, if in the United States, or in units of 100, if in the United Kingdom. Hence, a deep discount US bond, selling at a price of 75.26, indicates a selling price of $752.60 per bond sold. (Often, bond prices are quoted in points and thirty-seconds of a point, rather than in decimal form.) Some short-term bonds, such as the U.S. Treasury Bill, are always issued at a discount, and pay par amount at maturity rather than paying coupons. This is called a discount bond.

The market price of a bond is the present value of all future interest and principal payments of the bond discounted at the bond's yield, or rate of return. The yield represents the current market interest rate for bonds with similar characteristics. The yield and price of a bond are inversely related so that when market interest rates rise, bond prices generally fall and vice versa.

The market price of a bond may include the accrued interest since the last coupon date. (Some bond markets include accrued interest in the trading price and others add it on explicitly after trading.) The price including accrued interest is known as the "flat" or "dirty price". ( See also Accrual bond.) The price excluding accrued interest is sometimes known as the Clean price.

The interest rate adjusted for the current price of the bond is called the current yield or earnings yield (this is the nominal yield multiplied by the par value and divided by the price).

Taking into account the expected capital gain or loss (the difference between the current price and the redemption value) gives the "redemption yield": roughly the current yield plus the capital gain (negative for loss) per year until redemption. The relationship between yield and maturity for otherwise identical bonds is called a yield curve.

Bonds markets, unlike stock or share markets, often do not have a centralized exchange or trading system. Rather, in most developed bond markets such as the U.S., Japan and western Europe, bonds trade in decentralized, dealer-based over-the-counter markets. In such a market, market liquidity is provided by dealers and other market participants committing risk capital to trading activity. In the bond market, when an investor buys or sells a bond, the counterparty to the trade is almost always a bank or securities firm acting as a dealer. In some cases, when a dealer buys a bond from an investor, the dealer carries the bond "in inventory." The dealer's position is then subject to risks of price fluctuation. In other cases, the dealer immediately resells the bond to another investor.

Bond markets also differ from stock markets in that investors generally do not pay brokerage commissions to dealers with whom they buy or sell bonds. Rather, dealers earn revenue for trading with their investor customers by means of the spread, or difference, between the price at which the dealer buys a bond from one investor--the "bid" price--and the price at which he or she sells the same bond to another investor--the "ask" or "offer" price. The bid/offer spread represents the total transaction cost associated with transferring a bond from one investor to another.

Investing in bonds

Bonds are bought and traded mostly by institutions like pension funds, insurance companies and banks. Most individuals who want to own bonds do so through bond funds. Still, in the U.S., nearly ten percent of all bonds outstanding are held directly by households.

As a rule, bond markets rise (while yields fall) when stock markets fall. Thus bonds are generally viewed as safer investments than stocks , but this perception is only partially correct. Bonds do suffer from less day-to-day volatility than stocks, and bonds' interest payments are higher than dividend payments that the same company would generally choose to pay to its stockholders. Bonds are liquid it is fairly easy to sell one's bond investments, though not nearly as easy as it is to sell stocks and the certainty of a fixed interest payment twice per year is attractive. Bondholders also enjoy a measure of legal protection: under the law of most countries, if a company goes bankrupt, its bondholders will often receive some money back (the recovery amount), whereas the company's stock often ends up valueless. However, bonds can be risky:

  • Fixed rate bonds are subject to interest rate risk , meaning that their market prices will decrease in value when the generally prevailing interest rates rise. Since the payments are fixed, a decrease in the market price of the bond means an increase in its yield. When the market's interest rates rise, then the market price for bonds will fall, reflecting investors' improved ability to get a good interest rate for their money elsewhere perhaps by purchasing a newly issued bond that already features the newly higher interest rate. Note that this drop in the bond's market price does not affect the interest payments to the bondholder at all, so long-term investors need not worry about price swings in their bonds and do not suffer from interest rate risk.

However, price changes in a bond immediately affect mutual funds that hold these bonds. Many institutional investors have to "mark to market" their trading books at the end of every day. If the value of the bonds held in a trading portfolio has fallen over the day, the "mark to market" value of the portfolio may also have fallen. This can be damaging for professional investors such as banks, insurance companies, pension funds and asset managers. If there is any chance a holder of individual bonds may need to sell his bonds and "cash out" for some reason, interest rate risk could become a real problem. (Conversely, bonds' market prices would increase if the prevailing interest rate were to drop, as it did from 2001 through 2003.) One way to quantify the interest rate risk on a bond is in terms of its duration. Efforts to control this risk are called immunization or hedging.

  • Bond prices can become volatile if one of the credit rating agencies like Standard & Poor's or Moody's upgrades or downgrades the credit rating of the issuer. A downgrade can cause the market price of the bond to fall. As with interest rate risk, this risk does not affect the bond's interest payments, but puts at risk the market price, which affects mutual funds holding these bonds, and holders of individual bonds who may have to sell them.
  • A company's bondholders may lose much or all their money if the company goes bankrupt. Under the laws of many countries (including the United States and Canada), bondholders are in line to receive the proceeds of the sale of the assets of a liquidated company ahead of some other creditors. Bank lenders, deposit holders (in the case of a deposit taking institution such as a bank) and trade creditors may take precedence.

There is no guarantee of how much money will remain to repay bondholders. As an example, after an accounting scandal and a Chapter 11 bankruptcy at the giant telecommunications company Worldcom, in 2004 its bondholders ended up being paid 35.7 cents on the dollar. In a bankruptcy involving reorganization or recapitalization, as opposed to liquidation, bondholders may end up having the value of their bonds reduced, often through an exchange for a smaller number of newly issued bonds.

  • Some bonds are callable, meaning that even though the company has agreed to make payments plus interest towards the debt for a certain period of time, the company can choose to pay off the bond early. This creates reinvestment risk, meaning the investor is forced to find a new place for his money, and the investor might not be able to find as good a deal, especially because this usually happens when interest rates are falling.

Bond indices

A number of bond indices exist for the purposes of managing portfolios and measuring performance, similar to the S&P 500 or Russell Indexes for stocks. The most common American benchmarks are the Lehman Aggregate, Citigroup BIG and Merrill Lynch Domestic Master. Most indices are parts of families of broader indices that can be used to measure global bond portfolios, or may be further subdivided by maturity and/or sector for managing specialized portfolios.

References

  1. Eason, Yla (June 6, 1983). "Final Surge in Bearer Bonds" New York Times .
  2. Quint, Michael (August 14, 1984). "Elements in Bearer Bond Issue". New York Times .
  3. no byline (July 18, 1984). "Book Entry Bonds Popular". New York Times .
  4. Batten, Jonathan A.; Peter G. Szilagyi (2006-04-19). " Developing Foreign Bond Markets: The Arirang Bond Experience in Korea " (PDF). IIS Discussion Papers (138). Retrieved on 2007-07-06.
  5. Gwon, Yeong-seok. (Announcement: first 'Kimchi Bonds' next month) ", The Hankyoreh, 2006-05-24. Retrieved on 2007-07-06.
  6. Chung, Amber. " BNP Paribas mulls second bond issue on offshore market ", Taipei Times, 2007-04-19. Retrieved on 2007-07-04.
  7. Areddy, James T.. " Chinese Markets Take New Step With Panda Bond ", The Wall Street Journal, 2005-10-11. Retrieved on 2007-07-06.

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